Far from settled

Planning for an uncertain future after catastrophic injury

Alexandra Macqueen 7 April, 2020 | 1:39AM

Sick tree

Melanie is 51 and needs to make a decision about her finances. In 2012, while driving across her Ontario town, she was hit by another driver – leaving her with a traumatic brain injury.

Melanie received a settlement (one of two) of just under $1,000,000, which she’s in the process of investing to provide regular income (until recently, she’d kept it in cash). Now, in 2020, she’s due to receive the second. She needs to choose whether she should take this second settlement amount – expected to be in the range of $600,000 to $800,000 – as a lump sum, or in the form of a “structured settlement.”

Ontario’s “threshold no-fault” car insurance system provides that if your injuries from a car accident exceed a specified threshold, determined monetarily or by the severity of your injuries, you can sue the at-fault driver. Melanie’s first settlement was via this tort-based system. Her second settlement will be made from her own insurer through Ontario’s Statutory Accident Benefits system, which pays for expenses not covered by healthcare, to replace lost income, and more.

To Melanie, the advantages of taking this second amount as a lump sum seem obvious: the funds are liquid, and she can manage them herself. A structured settlement, on the other hand, would provide guaranteed, tax-free income over a term she selects, such as 15 or 20 years, or for her lifetime – but there is no opportunity to “manage” the funds and, while periodic lump sums can be included in a structured settlement, no other liquidity.

Income from a structured settlement isn’t taxable, so long as certain conditions are met. For example, the insurance company must buy a single premium annuity to produce the stream of payments outlined in the settlement agreement. This means, in turn, that a structured settlement won’t lead to clawbacks of income-tested benefits such as Old Age Security and the Guaranteed Income Supplement. The income from a structured settlement is intended to complement, not replace, existing government benefits such as the Canada Pension Plan disability benefit and provincial disability benefits programs.

The settlement can be structured to provide periodic lump sums as well as regular monthly income and indexing, whether to the Consumer Price Index or to a predetermined yearly amount, such as 2%.

“How do I decide?” A review of Melanie’s options

Here’s a look at how the two options compare:

  Structured Settlement  Lump Sum 
Form of payment         

 

-Monthly income for a specified term or Melanie’s lifetime

-Periodic lump sum distributions are possible, in addition to monthly income

 

A single sum
Tax implications                       All payments are tax-free  

-Some portion can be sheltered in tax-advantaged accounts, depending on available contribution room

-Withdrawals from tax-advantaged accounts (except TFSA) are taxable

-Income and distributions from non-registered accounts are taxable

 

Risks:

Longevity

Market

Inflation

 

-If the settlement is structured as a life annuity, longevity risk is eliminated

-No market risk, as the funds are guaranteed

-Partial or full inflation protection can be incorporated, at a cost

 

 

-No longevity risk protection, unless a life annuity is purchased, which won’t qualify for tax-free payments

-Market risk is present but can be reduced, depending on how the funds are allocated

-No direct inflation protection unless inflation-linked products are purchased, although equity allocations may provide some inflation protection

 

Impact on Government Benefits

 

 

Payments are not included as taxable income for income-tested government benefits (OAS, GIS)

 

 

Withdrawals and distributions from non-registered and registered accounts (except TFSA) may lead to clawbacks of income-tested government benefits (OAS, GIS)

Cost  

 

-Lawyer fees are paid from settlement amount

-No ongoing management fees – annuity costs are embedded in the settlement

 

-Lawyer fees are paid from settlement amount

-Ongoing management fees

What are Melanie’s needs?
Currently, Melanie’s income needsare relatively modest, although she participates in daily – and costly – occupational therapy. Until she settles with her insurance company to cover the future cost of her care needs, this expense is covered by the insurance company and reduces the size of the eventual settlement she will receive. Once she settles, however, she will need to pay for her rehabilitation therapy directly. To cover these future care costs, Melanie has several structured settlement options. Assuming a settlement of $800,000 and payments rising by 2% per year, Melanie has received quotes for payments of approximately $5,000 per month to her age 65, $3,500 per month to her age 70, or $3,000 per month to her age 75. Which of these should she choose – or should she opt to take the lump sum?

Comparing cash flows
In order to help Melanie make a decision between her two options, as in last month’s column we put some numbers to her dilemma. Specifically, we compared Melanie’s structured settlement option – $3,000 per month to her age 75 and indexed by 2% yearly – to the same $800,000 invested in a non-registered account (she has no available room in tax-sheltered accounts). If she selects this second option, we assumed she’d invest in a relatively low-risk, balanced portfolio with an expected return of 5.15% (using FP Canada’s rate of return assumptions).Then, to compare the two options, we adjusted the withdrawals from the non-registered portfolio, using Ontario tax rates, to ensure Melanie would have the same after-tax monthly income from the portfolio as she would from the structured settlement. (For simplicity, we assumed Melanie would have no other taxable income were she to take the lump sum option. In reality, she has a CPP disability benefit, as well as taxable income from her previous settlement.) The result? Given this set of assumptions, withdrawals from Melanie’s non-registered portfolio fall short of the annuity at her age 72, and her portfolio is completely depleted by her age 73, compared to the structured settlement which lasts to her age 75. That is, even the higher expected return from the portfolio isn’t sufficient to overcome the tax efficiency of the structured settlement annuity.In addition, if she opts for the taxable portfolio, Melanie would need to take market risk with no guarantees that income would be generated smoothly over time.

Addressing uncertainties through risk management
A structured settlement is designed to take risk off the balance sheet for people who have lifetime income needs as a result of catastrophic injury.In this case, Melanie is faced with two options: an annuity that provides guaranteed, tax-free income, or a lump-sum settlement that provides liquidity but requires her to pay tax and accept investment risk. Modelling the outcomes – as we’ve started to do here – can help provide proactive insight when irreversible, high-stakes decisions are required.

With thanks to David Field at Papyrus Planning for assistance with financial modelling and income tax calculations.

About Author

Alexandra Macqueen  Alexandra Macqueen CFP®, regularly consults to businesses, organizations and other planners on retirement income planning, annuity analytics, and other personal financial topics. Follow her on Twitter at @moneygal.  

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